In the World of Banks, Bigger Can Be Better

Legitimate concern about the risks to taxpayers and the economy posed by banks that are “too-big-to-fail” has prompted some observers, among them Simon Johnson, former chief economist of the International Monetary Fund, to favor draconian limits on financial institution size. This is misguided. There are sizable gains from retaining large, complex, global financial institutions–and other ways to credibly protect taxpayers from the cost of government bailouts.

Governments currently have trouble allowing large, complex financial institutions to enter bankruptcy, or receivership in the case of banks, because there is no orderly means for transferring control of assets and operations, including the completion of complex transactions with many counterparties perhaps in scores of countries via thousands of affiliates. The problem is important to resolve. The inability of regulators to agree on who had claim to which assets in the case of the Lehman bankruptcy, for example, has substantially prolonged the resolution of that bankruptcy.

Yet the challenge of coordinating the efforts among different countries’ regulators can be met through prearranged, loss-sharing arrangements that assign assets to particular subsidiaries based on clear rules. This would make it possible to transfer control over the assets and operations of a large international financial institution in an orderly fashion, in case of its failure. This process could be handled by the courts for nonbank failures and the Federal Deposit Insurance Corp. for banks. With such arrangements in place, governments will have no reason (or excuse) to bail out large, international institutions.

But is it worth the trouble to preserve large financial institutions? Emphatically, it is.

Large-scale global finance has also expanded the supply of credit to emerging market economies.

Oliver Williamson, an economist at the University of California, Berkeley, just won the Nobel Prize for his pathbreaking work on the “boundaries of the firm,” specifically for arguing that it can be more efficient to extend the boundaries of a single firm than for independent firms to contract with each other in the market. That theory explains why nonbank corporations operate world-wide supply chains.

International trade today, unlike the 19th and early 20th centuries, is largely driven by those supply chains. Intermediate goods, not final goods, account for most of international trade, and the same firms that import the bulk of goods into the U.S. also account for the bulk of exports. This underlying reality is the background factor that helps explain why some financial firms also need to be large.

First and foremost, they need to be large to operate on a global scale–and they need to do so because their clients are large and operate globally. Small, local banks simply could not provide global corporations the same physical capabilities for trade finance, foreign exchange contracting, and global capital access that large global financial institutions can.

Second, there are economies of scope when financial firms combine different products within the same firm (lending and foreign-exchange swaps, for example). A financial firm able to offer multiple products to a customer means savings in marketing costs and in the costs of information production (about the creditworthiness of clients, for example). Economies of scope among products also imply economies of scale within finance suppliers, since small financial firms cannot afford the overhead costs of building platforms with many complex products.

True, some empirical studies in the field of finance have failed to find big gains from mergers. But those studies measured gains to banks only, and measured only the performance improvements of recently consolidated institutions against other institutions, many of which had improved their performance due to previous consolidation.

Yet even unconsolidated banks have improved their performance under the pressure of increased competition following the removal of branching restrictions, which permitted the consolidation wave in banking. And when an entire industry is involved in a protracted consolidation wave, the best indicator of the gains from consolidation is the performance of the industry as a whole. One study of bank productivity growth during the heart of the merger wave (1991-1997), by Kevin Stiroh, an economist at the New York Federal Reserve, found that it rose more than 0.4% per year.

Third, many of the gains of consolidation accrued to customers, not banks, in the form of cheaper and better financial services. For example, my research shows that from 1980 to 1999, after controlling for changes in the mix of firms, the underwriting costs of accessing the public equity market fell by more than 20%. These declining costs encouraged an expanded use of the market particularly by young, growing firms.

Large-scale global finance has also expanded the supply of credit to emerging market economies. That’s transformed the political economy of those economies very much for the better, by undermining domestic crony-capitalist networks. Indeed, perhaps the greatest accomplishment of global finance in the past two decades has been the replacement of crony banking networks in emerging market countries with branches of large global banks.

Fourth, global financial institutions also have made stock, bond and foreign exchange markets globally integrated and more efficient. Global financial institutions are the institutions that provide the funds for arbitrage across markets, which ensure global market integration.

Research in the 1970s and early 1980s by international economists like Stanford University’s Ron McKinnon bemoaned the inefficiency of foreign exchange markets due to the lack of arbitrage funding, which promoted exchange rate volatility and limited the ability of exporters and importers to hedge their risks. Today the foreign exchange markets for most currencies are extremely active for a wide variety of currencies. Important developing countries now enjoy deep markets for currency trading against the major currencies, which promotes greater access to trade and international capital markets.

Limiting the size, complexity and global reach of financial institutions is fraught with downsides for the international economy. We can solve the too-big-to-fail problem without destroying global finance. It certainly is worth a try.